DOL Issues Guidance on 2020 Investment Advice Exemption

By George Michael Gerstein and John “JJ” Dikmak Jr.

Just yesterday, the U.S. Department of Labor (“DOL”) released a set of Frequently Asked Questions (“FAQs”) designed to clarify certain aspects of Prohibited Transaction Exemption 2020-02, Improving Investment Advice for Workers & Retirees (PTE 2020-02). The exemption enables investment advice fiduciaries to ERISA plans and IRAs to receive a wide range of compensation (e.g., commissions, 12b-1 fees, revenue sharing, etc.) as a result of the advice without running afoul of the applicable prohibited transaction rules. As described by the DOL, “[t]he exemption offers a compliance option to investment advisers, broker-dealers, banks, and insurance companies (financial institutions) and their employees, agents, and representatives (investment professionals) that is broader and more flexible than pre-existing prohibited transaction exemptions.” We summarize some of the key takeaways from the FAQs below:

  • PTE 2020-02 is in effect (February 16, 2021). There was some confusion over this due to a memorandum from Ronald Klain, Chief of Staff to the President, regarding a regulatory freeze. The (new) DOL, however, was pleased enough with PTE 2020-02, a Trump-era rulemaking, that it waved it through. The transition period for parties to devise mechanisms to comply with the provisions in the exemption remains in place until December 20, 2021.
  • The DOL hinted at further sub-regulatory guidance and/or returning to the fiduciary investment advice regulation. No promises were made or timetables offered.
  • The DOL reiterated that a “single, discrete instance of advice to roll over assets from an employee benefit plan to an IRA” would generally not give rise to investment advice under ERISA. But, such communication could constitute investment advice if it were part of an ongoing relationship or the beginning of an intended future ongoing relationship that an individual has with the investment advice provider.
  • The DOL reminded the industry that boilerplate, fine print disclaimers that investment advice is not being provided generally won’t cut it. This echoes sentiment the DOL expressed in 2020. However, “[w]ritten statements disclaiming a “mutual” understanding or forbidding reliance on the advice as “a primary basis for investment decisions” may be considered in determining whether a mutual understanding exists, but such statements will not be determinative.” Ultimately, whether there is a “mutual” understanding that investment advice is being provided is based on the totality of the facts and circumstances.
  • The DOL reiterated that PTE 2020-02 provides relief for rollover recommendations that result in a prohibited transaction, so long as the exemption’s conditions are satisfied.
  • Investment professionals and financial institutions can provide investment advice, despite having a financial interest in the transaction, as long as the advice meets the best interest standard. Under this standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the investment professional or financial institution. Investment professionals may receive payments for their advice within this framework.
  • Prior to engaging in a transaction under the exemption, a financial institution must give the retirement investor a written description of its material conflicts of interest arising out of the services and any investment recommendation. The disclosure should allow a reasonable person to assess the scope and severity of the financial institution’s and investment professional’s conflicts of interest.  The DOL cautioned that the disclosure should be more than simply having the retirement investor “check the box” to confirm that they know of the conflicts.
  • Financial institutions and their investment professionals need to consider and document their analysis of why a rollover recommendation is in a retirement investor’s best interest. For recommendations to roll over assets from an employee benefit plan to an IRA, the DOL listed the following “relevant” non-exhaustive factors to consider: (1) the alternatives to a rollover, including leaving the money in the investor’s employer’s plan, if permitted; (2) the fees and expenses associated with both the plan and the IRA; (3) whether the employer pays for some or all of the plan’s administrative expenses; and (4) the different levels of services and investments available under the plan and the IRA. The DOL also elaborated on what other factors would be part of a prudent analysis.
  • The DOL reminded financial institutions that they “must take special care in developing and monitoring compensation systems to ensure that their investment professionals satisfy the fundamental obligation to provide advice that is in the retirement investor’s best interest.” With carefully considered compensation structures, financial institutions can avoid structures that a reasonable person would view as creating incentives for investment professionals to place their interests ahead of the interest of the retirement investor. Thus, quotas, bonuses, prizes and performance standards are likely out. On the flip side, a financial institution could provide level compensation for recommendations to invest in assets that fall within reasonably defined investment categories (e.g., mutual funds), and provide heightened supervision as between investment categories (e.g., between mutual funds and fixed annuities), to the extent that it is not possible for the institution to eliminate conflicts of interest between these categories. The DOL also reminded financial institutions that the exemption requires they address and mitigate firm-wide conflicts.
  • Unlike the 2016 rulemaking, PTE 2020-02 does not impose contract or warranty requirements on the financial institutions or investment professionals responsible for compliance. Nor does the exemption expand an investors’ ability to enforce their rights in court or create any new legal claims beyond those in Title I of ERISA and the Code.

Financial institutions seeking additional information about their obligations under PTE 2020-02 may consider our initial analysis on PTE 2020-02 and its related rulemaking.

Are You Sure You Can Use the QPAM Exemption?

For many investment managers, the ability to act as “QPAM” is essential to managing retirement account assets. Indeed, status as a QPAM likely provides a sort of credentialing boost in the eyes of prospective plan clients and, more importantly, signals the investment manager’s ability to rely upon the “QPAM Exemption,” a highly versatile exemption used to cure various prohibited transactions under ERISA and Section 4975 of the Internal Revenue Code when it exercises discretion over plan assets. To be a QPAM, however, is not tantamount to satisfying the QPAM Exemption. Moreover, the QPAM Exemption itself is subject to myriad conditions, the failure to meet only one of which can wreak havoc on a compliance strategy. Here, we provide an overview and highlight potential trap doors in a Q&A format.

What is a QPAM?

A QPAM is a “qualified professional asset manager” within the meaning of Part VI(a) of the QPAM Exemption (Prohibited Transaction Class Exemption 84-14). An investment adviser registered under the Advisers Act, for example, is generally eligible to be a QPAM, provided it has total client assets under management of more than $85 million as of the last day of its most recent fiscal year and more than $1 million in shareholders’ or partners’ equity. Thus, newly formed investment managers may need to rely on an alternative exemption for trading, such as Section 408(b)(17) of ERISA, during its first year of operations.

What is the QPAM Exemption, and why is it important?

Fiduciaries of employee benefit plans subject to Title I of ERISA and plans subject to Section 4975 of the Internal Revenue Code (e.g., IRAs) must avoid entering into prohibited transactions for which no exemption is available. A prohibited transaction includes the purchase and sale of securities or other property to a “party in interest.” For example, a swap transaction with a bank would be a prohibited transaction if the bank is a party in interest to the plan client. Virtually all financial service firms will assume they are a party in interest. This is why nearly all ISDA Schedules will include representations from the investment manager that the QPAM Exemption will be met with respect to the transactions. Simply, an investment manager may be hard-pressed to enter into many types of transactions on behalf of plan clients without representing that it can satisfy the QPAM Exemption (while the bank-counterparty in this example may seek a representation from the investment manager that it is a QPAM, the bank would only be interested in knowing that in the context of ensuring the QPAM Exemption can otherwise be met).

To be fair, the QPAM Exemption is not the only game in town. It is, however, a tried and true exemptive approach that facilitates many types of trades an investment manager may want to conduct on behalf of a plan client. Reliance on alternative exemptions may be feasible from a legal standpoint but nevertheless could slow negotiations down. Practically speaking, then, it is important for most investment managers who have discretionary responsibility over plan assets to become familiar with the nuances of the QPAM Exemption and ultimately comply with it.

For purposes of the prohibited transaction rules, is it enough to be a QPAM?

An investment manager’s status as a QPAM is important, but only insofar as the rest of the QPAM Exemption can also be satisfied. In other words, the QPAM Exemption contains several conditions; to meet the definition of a QPAM itself is but one condition.

What are the other conditions of the QPAM Exemption?

Here is an overview of the other key conditions of the QPAM Exemption:

  1. The investment manager (i.e., the QPAM) acknowledges in writing that it is a fiduciary to the plan client.
  2. The entity appointing the QPAM (or entering into the investment management agreement with the QPAM) is not the counterparty (or affiliate) with respect to the transaction. There is a useful exception to this condition for commingled investment funds where no plan (or plans established by the same employer) holds a 10 percent or more interest in the fund.
  3. The counterparty is not the QPAM or otherwise related to the QPAM (i.e., the QPAM Exemption does not cover self-dealing prohibited transaction issues).
  4. No plan, when combined with the assets of other plans established by the same employer, represents more than 20 percent of the QPAM’s total client assets under management.
  5. The terms of the transaction are negotiated by the QPAM, and the QPAM makes the decision to enter into the transaction on behalf of the plan.
  6. The terms of the transaction are at least as favorable to the plan as the terms generally available in an arm’s length transaction between unrelated parties.
  7. Neither the QPAM, any affiliate, nor certain other persons have been convicted of certain U.S. or non-U.S. crimes (e.g., larceny, forgery, theft, counterfeiting, etc.) within the past 10 years. This condition has proven challenging for some large financial services firms with affiliates around the globe that may have been convicted of non-U.S. crimes.

Each and every one of these conditions have to be met.

How should an investment manager proceed?

As evident from the conditions outlined above, the QPAM Exemption cannot be put on autopilot. Investment managers should be cognizant that satisfaction of the QPAM Exemption needs to be battle-tested prior to making a contractual representation to a client or a counterparty that the exemption can be complied with by the investment manager. Investment managers should also be sensitive to the fact that some clients of theirs may conflate an investment manager’s status as a QPAM with the investment manager’s ability to satisfy the QPAM Exemption. Should this occur, both parties may have a false sense of security that the QPAM Exemption can be met for the investment mandate. The existence of non-exempt prohibited transactions by an investment manager can result in severe monetary penalties and reputational harm. If the QPAM Exemption is unavailable for some reason, one or more alternative exemptions may be available, though they should be evaluated prior to entering into the investment management agreement and any trading.

DOL to Revisit Trump ESG-Related Rules

By George Michael Gerstein and John “JJ” Dikmak Jr.

On March 10, the U.S. Department of Labor (DOL) announced that until further notice, it will not enforce certain final rules published at the tail-end of the Trump administration. Specifically, the DOL will revisit, and, in the interim, will cease to enforce, the “Financial Factors in Selecting Plan Investments” and “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights” rules which were published in November and December of 2020, respectively. These rules created requirements for plan fiduciaries subject to the U.S. Employee Retirement Income Security Act of 1974 (ERISA) to consider only pecuniary interests when selecting investments and exercising voting rights. Though the rules certainly cover environmental, social and/or governance (ESG)-driven investment decisions, proxy votes and the exercise of other shareholder rights, all ERISA fiduciaries, regardless of strategy, are subject to the rules. Please note that the rules have not been rescinded. Fiduciaries, therefore, may remain subject to private litigation risk for lack of compliance.

Some have expressed concern that the Financial Factors rule effectively prohibited the use of ESG factors by ERISA fiduciaries. We disagree. ERISA fiduciaries that treat one or more E, S and or/G factors as material to investment performance may continue to do so both under ERISA itself and under the Financial Factors rule, provided the fiduciary follows a prudent process and can point to some data or other evidence that forms the fiduciary’s belief that such factor is an important risk/return consideration, and as otherwise specified under the rule. ESG integration is one such example. The Financial Factors rule also largely retained the longstanding separate DOL test that had to be met in order for an ESG factor to be selected for non-investment performance reasons.

Fiduciaries wishing to proceed with ESG integration may continue to do so without undue risk, provided they follow the core principles and requirements under ERISA, as largely reflected in the Financial Factors rule. Please consider our prior analysis of the Financial Factors rule and the Proxy Voting rule.

Join George Michael Gerstein for a PLANSPONSOR Webinar: ESG Factors in Investment Selection

For several presidential administrations now, there has been some back and forth about the place for environmental, social and governance (ESG) investing in retirement plans. Last year, the DOL proposed controversial regulations seeming to suppress the use of ESG investments in retirement plans; however, when final regulations came out, the DOL’s stance was softened.

Join PLANSPONSOR and retirement industry sources for a webinar in which you will learn:

  • What the DOL’s latest regulations say about the use of ESG investments in retirement plans;
  • How retirement plan sponsors can abide by their fiduciary duties when making investment selections based on ESG factors;
  • The different ways plan sponsors can include ESG investments in retirement plans.

When: Thursday, March 18 at 2 p.m. ET

Panelists:

George Michael Gerstein, Fiduciary Governance Group Co-Chair, Stradley Ronon Stevens & Young, LLP

Neal Weaver, CEO and Co-Founder, Leafhouse Financial

Eraj Zaidi, Vice President, ESG Client Success at ISS ESG

Moderator:

Rebecca Moore, Managing Editor, PLANSPONSOR Digital, ISS Media

REGISTER